Interest-rate risk is the possibility that changes in rates or yield curves will reduce market value, earnings, cash flow, or economic value.
Interest-rate risk is the possibility that changes in market interest rates or yield curves will reduce the value of an asset, increase a funding cost, narrow income, or change the economic value of assets and liabilities. It affects bonds, loans, deposits, derivatives, businesses with debt, and financial institutions whose assets and liabilities reprice at different times.
Interest-rate risk is broader than the statement “bond prices fall when rates rise.” It includes price sensitivity, repricing mismatch, nonparallel yield-curve changes, basis differences between reference rates, embedded options, and reinvestment of future cash flows.
| Holder or entity | Main exposure | Example |
|---|---|---|
| Bond investor | Market value and reinvestment income | A long-duration bond falls when required yields rise |
| Borrower | Interest expense and refinancing terms | Floating-rate debt resets at a higher benchmark |
| Lender | Asset yield and funding margin | Deposit costs rise before loan yields reset |
| Bank | Net interest income and economic value of equity | Asset and liability cash flows have different timing |
| Pension or insurer | Asset-liability mismatch | Liability value and asset value respond differently to rates |
| Derivatives user | Curve, basis, volatility, and collateral | A swap hedge does not match the underlying exposure |
The OCC describes interest-rate risk as comprising repricing, basis, yield-curve, and options risk. The Basel banking-book framework similarly emphasizes gap, basis, and option risk.
Repricing risk arises when rates on assets, liabilities, or off-balance-sheet positions reset or mature at different times. A bank may fund a five-year fixed-rate loan with deposits whose rates can change quickly. If deposit costs rise before loan income changes, net interest income can narrow.
Rates at different maturities do not always move together. A yield curve can shift, steepen, flatten, or twist. A position that is protected against a parallel move may remain exposed to nonparallel changes.
Assets and liabilities with similar reset dates may reference different benchmarks or adjust by different amounts. A loan tied to one reference rate and funding tied to another can produce changing spreads even when both are floating-rate.
Interest rates can change the behavior of borrowers, depositors, and issuers:
Contractual and behavioral options make cash-flow timing uncertain and can create nonlinear exposure.
Reinvestment risk is the possibility that coupons, principal, or other cash receipts must be reinvested at lower rates than assumed.
For a small yield change, modified duration provides a first-order approximation:
where:
A bond has a modified duration of 6.2. If its required yield rises by 0.75%, or 0.0075:
The estimated price decline is 4.65%. This is an approximation. Convexity, embedded options, spread changes, and a large or nonparallel rate move can produce a different result.
Modified Duration measures local yield sensitivity, not default probability or the maximum possible loss.
Assume a bank has, within a one-year bucket:
$70 million of rate-sensitive assets$90 million of rate-sensitive liabilitiesThe simple repricing gap is:
If rates on both sides rise immediately by one percentage point and remain changed for a full year, a simplified income estimate is:
This estimate assumes equal and immediate pass-through, stable balances, no caps or floors, no customer behavior changes, and a full-year effect. Real net interest income can differ because administered deposit rates, loan floors, basis changes, prepayments, new business, and timing are not identical.
| Measure | What it estimates | Important limitation |
|---|---|---|
| Repricing gap | Difference between rate-sensitive assets and liabilities by time bucket | Ignores magnitude differences, options, and economic value |
| Duration | Price sensitivity to a yield change | Local approximation; depends on cash-flow assumptions |
| DV01 or PV01 | Value change for a one-basis-point move | Usually tied to a selected curve or instrument |
| Key-rate duration | Sensitivity at selected yield-curve maturities | Multiple curve points and basis factors may still be needed |
| Economic value of equity | Present value of assets minus liabilities under rate scenarios | Highly dependent on cash-flow and discount assumptions |
| Net interest income simulation | Earnings effect over a stated horizon | Depends on pricing, growth, and behavioral forecasts |
| Stress testing | Effect of severe parallel and nonparallel scenarios | Scenario design does not define every possible outcome |
Banks often use both economic-value and earnings measures because the same position can affect near-term income and long-term value differently.
Duration Gap summarizes a bank’s asset-liability duration mismatch. Economic Value of Equity measures a broader present-value effect under stated cash-flow and rate assumptions.
| Risk | Primary question |
|---|---|
| Interest-rate risk | How do rate and yield-curve changes affect value, income, or cash flow? |
| Credit-spread risk | How does required compensation for credit and liquidity change? |
| Credit risk | Will the borrower or counterparty perform? |
| Inflation risk | Will cash flows lose purchasing power? |
| Reinvestment risk | At what rate can future receipts be reinvested? |
| Rollover or refinancing risk | Can maturing funding be replaced, and on what terms? |
| Liquidity risk | Can cash be raised or positions exited when required? |
Debt refinancing can expose a borrower to both rate and liquidity risk. A higher refinancing rate is a pricing effect; inability to obtain replacement funding is liquidity risk.
Possible controls include:
A hedge does not eliminate all risk. Contract maturity, benchmark, reset frequency, collateral, accounting treatment, and optionality can differ from the underlying exposure.
Measurement methods and regulatory requirements depend on the entity, product, accounting framework, and jurisdiction. Verify current rules and instrument terms.
This article is for financial education only. It does not evaluate a specific bond, loan, bank, derivative, or hedge and is not personalized investment, borrowing, accounting, legal, regulatory, or risk-management advice.